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Understanding Common Investments: Bonds

Bonds are issued by federal, state, and local governments, and by business corporations. U.S. government bonds are considered the safest, since the U.S. government has the highest credit rating of any borrower. State and local governments offer what are commonly referred to as "municipal bonds," which have the advantage of a federal tax exemption on interest paid.

Corporate Bonds While a share of stock represents partial ownership (equity) in a company, bonds represent debt payable by a company to the bondholders. A company issuing a bond agrees to repay the amount borrowed plus a specific rate of interest at an agreed time, the maturity date. Interest on bonds must be paid in good times or bad, like any other debts, which may be an attractive feature for investors seeking assured income.

Bond Ratings The quality of a bond usually can be determined by its rating. There are three publications that rate bonds:

Fitch

Moody's

Standard & Poor's.

They all rate the credit-worthiness of registered bonds on a grading scale of AAA to BBB. Any bond rating below that is considered to be a low-grade bond or a "junk" bond. The default potential of the debtor corresponds inversely to these bond ratings -- the higher the grade, the lower the risk., the lower the grade, the higher the risk. D ratings indicate payments are in default.

Impact of Bankruptcy The quality of a bond usually can be determined by its rating. Ask your broker for the rating of a particular bond you are interested in. If the issuer is creditworthy, bondholders can expect regular interest payments on specific dates. As with any investment, there is a risk that you may lose all or part of your investment should the company issuing the bonds go bankrupt. However, bondholders' claims in a bankruptcy must be satisfied before any payments are made to preferred or common stockholders.

Risks in Bonds Bond prices move in the direction opposite to that of interest rates, rising in puce when rates fall and vice versa. But individual bond issues can be hurt even if interest rates in general are falling. If for example, one of the rating services downgrades its opinion of the company's financial stability. A bond issue that's paying an interest rate noticeably higher than that of other bonds with similar maturity dates is probably being forced to pay more to compensate investors for the higher risk inherent in a lower safety rating. That, in a nutshell, is the situation with "junk" bonds: low ratings, high interest, high risk of default.

Some Common Corporate Bonds Corporate bond issues vary widely, but a few of the more common corporate bonds include the following:

Sinking Fund Bonds: Some bonds are backed by a "sinking fund" for which the issuer is required each year to set aside a certain amount of money to retire the securities when they mature.

Mortgage Bonds: Bonds in which a corporation pledges certain assets (real estate) as collateral to secure the bond payment.

Debentures: These bonds are not secured with collateral or specific property, but are backed by a corporation's general credit. Debentures are not necessarily less creditworthy than mortgage bonds, and in fact, some have top credit ratings.

Junk Bonds: These are high-yield, high-risk bonds of two types: those which are investment-grade when originally issued, but which have subsequently been downgraded, and those originally issued as low-grade bonds. The latter group includes bonds issued by low-rated companies to finance operations, as well as those issued in connection with corporate takeovers.

Convertible Bonds: A convertible bond gives its owner the privilege of exchange for other securities of the issuing company at some future date and under prescribed conditions.

Zero-Coupon Bonds: Zero-coupon bonds make no periodic interest payments, but instead are sold at a deep discount from face value. The buyer of such bond receives the rate or return by the gradual appreciation of the bond, which redeems at face value on a specified maturity date.